We've all been there. The refrigerator needs to be fixed. An air conditioning unit needs to be replaced. The kids are getting closer to college. You're running for president.
Okay, maybe not that last one (unless you're one of the 18 or so current or potential candidates vying for the GOP presidential nomination next year) but those were all reasons Republican presidential hopeful Senator Marco Rubio gave for recently cashing out one of his retirement accounts early. He's not alone. According to Fidelity, about one in three 401(k) investors has cashed out of a 401(k) before turning age 59 1/2.
Not only did they subject themselves to taxes and possible early withdrawal penalties, they also deprived themselves of the benefits of tax-deferred or even tax-free (in the case of Roth accounts) growth for retirement. Let's take Senator Rubio as an example. This article estimates his tax bracket at 33% and calculates that he would have lost about $30k to taxes and penalties out of the $68k he cashed out, netting him only $38k. Apparently the pledge he signed never to raise taxes doesn't apply to his own family.
This assumes the account was a pre-tax traditional IRA. If it was a Roth IRA, he would have only paid taxes and penalties on the earnings but that still wouldn't be a very good idea. Rubio is only 43 years only so he could plausibly have let the account grow another 25 years. If it earned just an average 6% return, the account would be worth over $290k tax-free. If he lived off his other assets in retirement and passed it on to his heirs at age 85, it would be worth over $785k, all tax-free.
So what could Rubio have done instead? Let's look at the pros and cons of his other options:
1) Dip into cash. His 2014 annual financial disclosure form reported him having between $151-$365k in checking and savings accounts. While most of us don't have that much cash lying around, hopefully you do have an emergency fund. If so, broken refrigerators and air conditioning units are examples of legitimate emergencies (especially where Rubio lives in South Florida with summer approaching) that those savings are for.
Pros: With interest rates on bank accounts still typically earning less than 1%, you're not exactly giving up much interest.
Cons: You may want to preserve the cash for a REAL emergency like unemployment (which Rubio faces if he loses the election since he's giving up his Senate seat to run) since it could be tough to borrow money without an income.
2) Sell assets. I don't know if he has any other investments in non-retirement accounts but Rubio lists income from rent so I assume he has at least one rental property that could be sold to raise cash.
Pros: If you held the investment for more than 12 months, you would owe a lower long-term capital gains tax rate than your ordinary income tax rate. In Rubio's case, that lower rate would be 18.8% including the “Medicare surtax” on income over $250K. If your tax bracket is 15% or below, the long term capital gains rate is ZERO. If you sell the investment at a loss, you can use it to offset other taxes, including up to $3k a year from your ordinary income taxes (losses over $3k can be carried forward indefinitely).
Cons: You still might have to pay taxes and you obviously lose any earnings you would have made on that money.
3) Use a home equity loan or line of credit. Rubio has a home equity line of credit of between $100-250k at 7.25% interest. Since the interest on up to $100k of mortgage debt not used to purchase or improve the home is tax-deductible, Rubio's net interest cost would only be 4.86%. While no one likes paying interest, there's a good chance his IRA investments would earn more than that if left alone.
Pros: The interest rate tends to be low and tax-deductible.
Cons: You need home equity and a decent credit score. Your home is also on the line if you can't make the payments.
4) Take a loan from your employer's retirement account. Rubio also has a Thrift Savings Plan account, which is like a 401(k) for federal government employees, that he could borrow from.
Pros: There's no credit check and the interest rate tends to be low and is paid back into your own account.
Cons: You need to have enough money in your account (you can generally borrow the lower of $50k or half of your vested account balance) and you lose any earnings you would have made on the money you borrow. Loans are usually only for up to 5 years. If you leave your job, any outstanding balance could be considered a withdrawal and subject to taxes and early withdrawal penalties. Finally, you have to pay taxes on the interest you paid when you eventually withdraw it in retirement, even though you paid the loan back with after-tax dollars. As a result, you end up paying taxes twice on that money.
5) Borrow from Family or Friends. Considering all the money he’s raising for his campaign, Rubio surely knows some people he could have borrowed some money from, although there are likely legal and ethical restrictions he would face as a member of Congress.
Pros: Unsecured loans from family or friends might offer easier “lending standards,” lower interest rates and preferential repayment terms.
Cons: It’s not always a good idea to possibly jeopardize relationships by mixing money and family or friends even if you’re not a politician.
6) Get a Peer-to-Peer lending loan. Peer-to-peer lending sites like Prosper and Lending Club allow you to borrow money from other people over the Internet. You can even use one of the sites to structure a loan from friends or family members. This should appeal to Rubio as a self-described “candidate of the future.” In fact, he's proposed a similar “Student Investment Plan” for student loans that would let investors pay students’ tuition in exchange for a percentage of their income for a set period of time after graduation.
Pros: The interest rates tend to be lower than you would get from a bank and you can include personal information that might make people amenable to lending to you.
Cons: They’re generally limited to $35k and you still have to pay interest based on regular metrics like your credit score and debt-to-income ratio.
7) Wait. There's no early withdrawal penalty once you reach age 59 1/2 (and have had the account open at least 5 years in the case of a Roth IRA). There are also exceptions to the penalty for IRAs such as up to $10k for a home purchase if you haven't owned one a home in the last 2 years and qualified education expenses for you, your spouse, or your children. Rubio could have avoided early withdrawal penalties just by waiting until one of children enters college. On the other hand, “waiting” just doesn’t seem like his style.
Pros: You can avoid early withdrawal penalties.
Cons: You may still have to pay taxes and you lose the ability to have your account continue growing tax-deferred or tax-free.
So which option should Rubio have taken? Any of them would probably have made more sense than cashing out his IRA. If Rubio does become President, let's hope he manages the nation's finances better than he managed his own here.
